Wednesday, 12 March 2008

Budget, competitiveness, and SMEs

Last week the CBI suggested that the way to fix the UK's "uncompetitive" economy is to reduce corporation tax from 28 to 18%. Economists might be surprised to hear that a tax on returns to capital investment is meant to have an effect on productivity and boost economic growth; but that is their thesis. Perhaps, to be fair, it would encourage an incremental increase in total investment across the economy, which should bring increased returns to labour productivity - but only if the returns are very marginal indeed will a 10% change in taxation on the profit make the difference between investing and not.

The evidence for the UK's decline in competitiveness is that India and Russia have now overtaken it in a survey of investor preferences by Ernst and Young. Surely there are bigger trends responsible for that change than the UK tax level?

Tax arguments in general are very weak grounds for talking about economic growth and business performance. It reminds me of the old IR35 argument. When people structure their companies around tax breaks, to hang onto an extra 5 or 10% of the cash they take out of the business, they often lose focus on the real opportunities to make more money - which come from transforming the effectiveness of your company through structure, invention or skills. A well-run professional services business should generate growth opportunities of 20-40% a year, which easily outweighs any tax advantage gained by manipulating the form or ownership of the business.

Special pleading from business lobby groups about factors external to your company is not the way to make your fortune. Working on what happens inside the business is.

In other budget news, two interesting points:

30% of government procurement is to go to SMEs in the next five years. At least, an committee is going to advise on the practicality of this goal. I think this is a great opportunity and an excellent way to stimulate overall economic competitiveness. SMEs do have some work to do on this, as the business will not fall into their laps by right, but this kind of carrot is just what will incentivise them to introduce sufficient discipline to their marketing and operations to be able to deliver larger contracts.

There will be a 20% increase in the funds available through the small firms loan guarantee scheme. Also, eligibility requirements will be relaxed and the Enterprise Capital Funds (government-backed mezzanine VC funds) will be expanded. A tricky one this - I said above that capital incentives are not a good way to stimulate productivity and competitiveness. However if we are going to have incentives, they are much better spent at the level where they may make the difference between a new business being started and not - since it seems clear that the rate of new business foundation is closely related to the level of innovation in the economy, which in turn correlates with overall competitiveness.

In classical economic terms this should not make any difference - if the business is going to make a positive capital return, someone will start it up anyway. However there are two reasons why the government may want to make an intervention here:

  • The capital market for SMEs may not be a classical economic market - some of the actors may be, strictly speaking, irrational. If this is the case, the (wise, enlightened) government may have a case for intervening. But a more compelling argument is:
  • There is a clear positive externality in the founding of a new business, going far beyond the return on capital investment to its owners. Some of this is in the increased economic activity from employment and purchasing by the business, and indirect stimulation of economic effects through the services it provides, all of which increase taxation revenue. The more important effect is in the introduction of new ideas into the economy. If a business brings a new operating model, a new process or an invention into being which would not otherwise occur, it will inevitably be copied or emulated by others. This does not provide a direct return to the owners - it may indeed produce a negative return for them - but it can have a transformational effect on the economy as a whole. Naturally we don't want to propose large-scale intervention to artificially create new businesses, since asymmetric returns (high upside, limited downside) means that capital will naturally be invested into innovative ideas anyway; but the externality argument must shift the balance at least a little towards state intervention.

As you would expect from a budget, the effects are mostly macroeconomic and so the subject of this blog - effective structures to use in individual organisations - is not directly addressed. But there are always influences between macro and microeconomics - remember neo-classical endogenous growth theory? This Government has often been accused of meddling in the details at the expense of economic efficiency, but I think this Budget finds a good balance.

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